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2 Hindustan Lever
Unilevers affiliate in India, Hindustan Lever, procures much of its toiletries product line from a Japanese company. Because of the shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. Hindustan Lever wishes to hedge a 8.5 million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen. Additionally, a common practice in India is for companies like Hindustan Lever to work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy. Assumptions 180-day account payable, Japanese yen () Spot rate (/$) Spot rate, rupees/dollar (Rs/$) Implied (calculated) spot rate (/Rs) 180-day forward rate (/Rs) Expected spot rate in 180 days (/Rs) 180-day Indian rupee investing rate 180-day Japanese yen investing rate Currency agent's exchange rate fee Hindustan Lever's cost of capital Hedging Alternatives 1. Remain Uncovered, settling A/P in 180 days at spot rate If spot rate in 180 days is same as current spot If spot rate in 180 days is same as forward rate If spot rate in 180 days is expected spot rate 2. Buy Japanese yen forward 180 days Settlement amount at forward rate (Rs) 3. Money Market Hedge Principal A/P () discount factor for yen investing rate for 180 days Principal needed to meet A/P in 180 days () Current spot rate (/Rs) Indian rupee, current amount (Rs) Hindustan Lever's WACC carry-forwad factor for 180 days Future value of money market hedge (Rs) 4. Indian Currency Agent Hedge Principal A/P () Current spot rate (/Rs) Current A/P (Rs) Plus agent's fee (4.850%) Hindustan's WACC carry-forwad factor for 180 days on fee Total future value of agent's fee (Rs) Total A/P, future value, A/P + fee (Rs) Evaluation of Alternatives The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives. 8,500,000.00 2.5257 3,365,464.34 163,225.02 1.0600 173,018.52 3,538,482.87 Certain 8,500,000.00 0.9926 8,436,724.57 2.5257 3,340,411.26 1.0600 3,540,835.94 3,541,666.67 2.4000 Certain 3,365,464.34 3,541,666.67 3,269,230.77 2.5257 2.4000 2.6000 Risky Risky Risky Values 8,500,000 120.60 47.75 2.5257 2.4000 2.6000 8.000% 1.500% 4.850% 12.00% Values
(120.60 / 47.75)
Risk Assessment
Certain
Alternatives 1. Remain Uncovered. Settle A/R in 90 days at current spot rate. If spot rate in 90 days is same as current (Rp750,000,000 / Rp8,800/$) If spot rate in 90 days is Rp9,400/$ (Rp750,000,000 / Rp9,400/$) If spot rate in 90 days is Rp9,800/$ (Rp750,000,000 / Rp9,800/$)
Values
Risk Assessment
$174,603.17
Risky
$175,531.91
Risky
$165,829.15
Risky
2. Sell Indonesian rupiah forward. A/R sold forward 90 days "Cost of cover" is the forward discount on Rp Analysis The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level. Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin. The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets. In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using forward cover. $165,829.15 -20.1% Certain
Analysis Net exposure at time of cash settlements: One year A/R due One year A/P due Net exposure
Values
Certain
This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian real, that it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian companies is considered a very good thing.
Cash settlement of the net position: Brazilian reais in one year at current spot rate Brazilian reais in one year at one year forward rate R$ 145,200,000.00 R$ 159,161,538.46 Risky Certain
In this case, however, because the real is selling forward at a considerable discount, the net long position -- if sold forward -yields considerably more real than the current spot rate. It should also be noted, however, that if the real were to fall considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.
Hedging Alternatives 1. Remain Uncovered, settling A/R in 90 days at market rate (20 million euros / future spot rate) If spot rate in 90 days is same as current If spot rate in 90 days is same as Credit Suisse forward rate If spot rate in 90 days is same as Barclays forward rate If spot rate in 90 days is expected spot rate 2. Sell euros forward 90 days Settlement amount at Credit Suisse forward rate Settlement amount at Barclays forward rate 3. Money Market Hedge Principal A/R in euros discount factor for euro borrowing rate for 90 days Borrow euros against 90-day A/R Current spot rate, $/euro US dollar current value Mattel's WACC carry-forward factor for 90 days Future value of money market hedge Evaluation of Alternatives
Values
$36,510,000.00 $36,630,000.00
Certain Certain
The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate).
Uncertain.
Certain.
The put option does not GUARANTEE the company of settling for the booked amount. The money market and forward hedges do; the money market yielding the higher proceeds. b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate: Money market, US$ up-front $168,245.38 Forward contract, US$, end of 90 days $171,188.91 (1 + x) 101.750% $168,245.38 (1+x) = $171,188.91 x 1.74954% For 90 days Breakeven rate, % per annum 6.998%
1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/ and the 6-month forward quote was $1.1130/. 2. Hedge in the money market. Redwall could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum. 3. Hedge with foreign currency options. June put options were available at strike price of $1.1000/ for a premium of 2.0% per contract, and September put options were available at $1.1000/ for a premium of 1.2%. June call options at $1.1000/ could be purchased for a premium of 3.0%, and September call options at $1.1000/ were available at a 2.6% premium. 4. Do nothing. Redwall could wait until the sales proceeds were received in June and September, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market. Assumptions 90-day Forward rate, $/ 180-day Forward rate, $/ US Treasury bill rate Redwall's borrowing rate, euros, per annum Redwall's cost of equity Options on euros June maturity options September maturity options Valuation of Alternative Hedges Amount of receivable, in euros a. Hedge in the forward market Amount of receivable, in euros Respective forward rates ($/) US dollar proceeds as hedged ($) Carry forward to Sept 1st at WACC Total US$ proceeds on Sept 1st Total of both payments b. Hedge in the money market Amount of receivable, in euros Discount factor for euro funds, period Current proceeds from discounting, euros Current spot rate ($/) Current US dollar proceeds Carry forward rate for the period US dollar proceeds on future date Total of both payments c. Hedge with options Amount of receivable, in euros Buy put options for maturities (% x spot value) Carry forward for the period Premium cost carried forward to Sept 1 Gross put option value if exercised Carried forward 3 months to Sept 1 Gross proceeds, Sept 1 Total net proceeds, after premium deduction, Sept 1 d. Do nothing (remain uncovered) Amount of receivable, in euros Ending spot exchange rate ($/) 2,000,000 ??? 2,000,000 ??? 2,000,000 ($44,000) 1.06 ($46,640) $2,200,000 1.03 $2,266,000 $4,391,376 2,000,000 ($26,400) 1.06 ($27,984) $2,200,000 ---$2,200,000 2,000,000 1.02 1,960,784 $1.1000 $2,156,863 1.06 $2,286,275 $4,528,582 2,000,000 1.04 1,923,077 $1.1000 $2,115,385 1.06 $2,242,308 2,000,000 $1.1060 $2,212,000 1.03 $2,278,360 $4,504,360 2,000,000 $1.1130 $2,226,000 ----$2,226,000 Values $1.1060 $1.1130 3.600% 8.000% 12.000% Strike ($/euro) $1.1000 $1.1000 Today is March 1 Date February 1 March 1 Exchange Rate ($/) $1.0800 $1.1000
The money market hedge provides the highest certain outcome. If Redwall believes the euro will strengthen versus the dollar over the coming months, and it is willing to take the currency risk, the put option hedges could be considered.
What are the costs and risk of each alternative? 1. Do nothing and exchange euros for dollars at end of 3 months Amount of euro receivable If spot rate in 3 months is the same as the forward rate US dollar proceeds of receivable would be Amount of euro receivable If spot rate in 3 months is the same as the current spot rate US dollar proceeds of receivable would be 2. Sell euro receivable forward at the 3-month forward rate Amount of euro receivable forward rate US dollar proceeds of receivable would be 3. Buy a put option on euros Amount of euro receivable Current spot rate ($/euro) Premium on put option, % Cost of put option (amount x spot rate x percent premium) If the spot rate at end of 3-months is less than strike rate the option is exercised yielding gross dollars of Less cost of option (premium) plus US$ interest on premium Net proceeds of A/R if option is exercised (this is Minimum) Summary of Alternatives Do Nothing Sell A/R forward Buy Put Option c) If Tek wishes to play it safe, it should lock in the forward rate.
Certain; Locked-in
4,000,000.00 1.2000 3.400% $163,200.00 Minimum is guaranteed; could be greater. Certainty? Risky Certain Minimum
d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3-month period, past $1.20/, then Tek might consider purchasing the put option on euros.
Certain; Locked-in
1 + (.0980 x 180/360)
c) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the yen may be depreciating (falling) versus the dollar over the coming 6-month period, somewhere below the option strike rate of 108/$, then Tek might consider purchasing the call option. If Tek is a bit more risk adverse, the forward rate is relatively attractive compared to the money market hedge.
Forward rate ($/) British pound investment rate British pound borrowing rate Put option on pound: Strike rate ($/) Premium ($/) Analysis and Evaluation If Tek wins the bid, it will be long foreign currency, having a 1.5 million pound position which is first backlog the an A/R. If and when Tek is awarded the bid, it would have 4 months (120 days) until cash settlement of the 1.5 million pound position. 1. Do Nothing -- Remaining Uncovered Wait 120 days and exchange pounds for dollars spot If the ending spot rate is the same as current spot rate If the ending spot rate is the same as the 4-month forward rate It could, however, be much lower. 2. Sell the pounds forward Selling 1 million pounds forward at the 4-month forward rate The primary problem with this is that if Tek does not win the bid, it has a forward contract to sell pounds which it will not earn. 3. Money market hedge -- borrow against expected receipts Expected receipts () Discount factor for 4-months at pound borrowing rate Proceeds from borrowing, now () Current spot rate ($/) Proceeds from borrowing, now ($) Carry-forward rate, 4 months @ Tek's WACC Value in 4 months of money market hedge ($) 4. Buy a put option on pounds at strike price of 1.58 Option, if exercised (if ending spot rate less than $1.85) Put option premium, up-front and the 4-months opportunity cost of premium Total premium expense Minimum dollars received if put option purchased
$2,762,700.00 $2,740,200.00
Risky Risky
$2,740,200.00
1/(1+(0.065 x 120/360))
1 + (.098 x 120/360)
The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bid's award. The advantage of the option is if Tek does not win the bid, the option can easily be sold.
Tek offers oscilloscopes and other off-the-shelf products through foreign-currency-denominated price lists. The prices are valid for 3 months only. One example is a Swedish price list expressed in Swedish kronor (SKr). In effect, customers are given a cost-free call option on products with a fixed dollar/krona exchange rate. During a typical 3-month period, Tek could expect to sell SKr 5,000,000 SKr 10,000,000 worth of products based on the price list. Since the SKr/$ exchange rate is likely to change during any 3-month period, Tek would like to hedge this transaction exposure (Teks Swedish business unit does believe the krona will be strengthening versus the dollar in the coming months). Nordea Bank (Sweden) has offered Tek the following quotes: Assumptions Expected sale over 90-day period, Swedish krona (SKr) Spot rate (SKr/$) 90-day forward rate (SKr/$) 3-month dollar interest rate 3-month krona deposit interest rate 3-month krona borrowing interest rate 3-month put option on krona: Strike rate (SKr/$) Premium Tek's weighted average cost of capital Values 5,000,000.00 7.4793 7.4937 4.000% 4.780% 6.500% 7.50 2.500% 9.800%
Could be more
Hedging Alternatives This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of sales will occur, and therefore what Tek's actual long position in Swedish krona will be. Value 1. Do Nothing -- Remain Uncovered. The ending spot rate at the time of settlement could be nearly anything. If the ending spot rate is the same as current spot rate (SKr/$) $668,511.76 If the ending spot rate is the same as forward (SKr/$) 2. Sell Swedish krona forward Sold forward 3-months at forward rate (SKr/$) However, remember that Tek does not know total sales. 3. Money market hedge Tek would borrow now against expected proceeds of (SKr) Discount rate of SKr interest rate for 90-days SKr proceeds from borrowing received up-front Exchanged at current spot rate (SKr/$) US dollars received now Tek carry-forward rate for US$ for 90 days Money market hedge proceeds in 90-days 4. Buy a 3-month put option on Swedish krona Proceeds will be option less premium if exercised (minimum) Exchange rate if exercised/not exercised (SKr/$) Amount of Swedish krona If exercised, it will yield a gross dollar amount of Put option premium Opportunity cost of premium Total future value of premium Minimum net dollar proceeds at end of 90 days (exercised gross amount less future value of premium) $667,227.14 $667,227.14
Certainty?
Risky Risky
Certain
5,000,000.00 0.98401 4,920,049.20 7.48 $657,822.15 1.025 $673,938.79 If exercised 7.50 5,000,000.00 $666,666.67 $16,712.79 409.46 $17,122.26 $649,544.41 Minimum If not exercised (random choice) 7.24 5,000,000.00 $690,607.73 $16,712.79 409.46 $17,122.26 $673,485.48
The money market hedge provides the highest certain US dollar receipts. (This is again a result of the significant increase in relative value arising from carrying-forward the dollars at Tek's WACC.)
If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr would have to fall to about SKr7.24 (shown above) in order for the put option to yield roughly the same amount of US dollars as the money market hedge.
Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however, Tek wishes to accept some degree of currency risk, and believes in the direciton of a stronger SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.22/$. This is still not superior to the Money Market Hedge. (The ending spot rate would need to be SFr1.20/$ or stronger to end up superior to the Money Market Hedge.)